- 15 Marks
Question
Companies A, B, and C are in the food retailing sector of the stock market. The following key stock market statistics are provided.
Food Retailers: Ordinary Shares, Key Stock Market Statistics:
| Company | A | B | C |
|---|---|---|---|
| Share Price (₦) | 2.10 | 1.80 | 2.30 |
| Earnings per Share (₦) | 0.30 | 0.25 | 0.35 |
| Dividend per Share (₦) | 0.18 | 0.15 | 0.25 |
Required:
a. Illustrating your answer by using data from the table above, define and explain the term P/E ratio, and comment on the way it may be used by an investor to appraise a possible share purchase. (8 Marks)
b. Using data in the above table, calculate the dividend cover for Companies C and B, and explain the meaning and significance of the measure from the point of view of equity investors. (7 Marks)
(Total 15 Marks)
Answer
a. Definition and Explanation of P/E Ratio:
The Price/Earnings (P/E) ratio is a valuation measure that compares the market price of a company’s shares to its earnings per share (EPS). It is calculated as:
Significance for Investors:
- The P/E ratio helps investors determine if a stock is overvalued or undervalued relative to its earnings. A higher P/E ratio may indicate that the market has high growth expectations for the company, while a lower P/E ratio may indicate undervaluation or a company facing challenges.
- Investors should compare the P/E ratio of a company to its peers or the industry average to assess relative value.
Dividend Cover is a ratio that measures how many times the earnings of a company cover its dividend payments. It is calculated as:
- A higher dividend cover suggests that the company has more than enough earnings to pay its dividends, indicating financial stability. For Company B, the dividend cover of 2.06 means the company can pay its dividends 2.06 times over, which is relatively healthy.
- For Company C, a dividend cover of 3.66 indicates slightly less coverage compared to Company B, but it still shows an ability to pay dividends comfortably.
- Low dividend cover may indicate potential future dividend cuts if earnings decline.
- Tags: Dividend Cover, Equity Valuation, Investment decisions, P/E Ratio, Stock Market Analysis
- Level: Level 3
- Topic: Dividend Policy
- Series: NOV 2022
- Uploader: Dotse